Meson Capital partnership letter for the second quarter ended June 30, 2016.
Our net performance for Q2 was (5.8)%, vs. indices (in order of relevancy for comparison) of: 1.4% HFRI Hedge Fund Equity Index, 3.8% Russell 2000 and 2.5% S&P 500. Our portfolio was approximately 10% net short on a beta adjusted basis for the quarter; our longs detracted 10.8% to returns while shorts contributed 5.0%. Our market neutral portfolio helps us focus on our business operations and ignore the headline driven, frothy stock market. “The less prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs.” – Warren Buffett
This quarter continued our streak of being negatively correlated with the stock market while we continued to make solid progress on operations within our businesses. Our portfolio positioning shined briefly during the “Brexit” debacle where the major indices were down 8% in two days – we were up 1% during the same period. In general we will not stand out when the market is reaching all-time highs. By design, our portfolio components will complement each other so we rarely get too excited or too worried. When the overall market moves sharply upward, the (short term) winners tend to be those that take the most imprudent risks.
The primary reason for our negative print for the quarter was due to the nearly 30% decline in one of our largest positions, InfuSystem. This was despite INFU posting a strong quarter with continued growth in the business – the stock has rebounded significantly this month and as of this writing, our portfolio is ahead of the indices. Medicare announced a regulatory change in reimbursement for infusion pumps during the quarter which we are working through to modify the business model. This is an area we have experience with, having dealt with ongoing regulatory changes since we joined the board in 2012. For better or worse, regulatory changes often have unintended effects including making it more challenging for the smaller market players to comply – often resulting in shuttering and market consolidation. For context and comfort, InfuSystem is the market leader and over 4x larger than its closest direct competitor.
Meson Capital – The Self-Immolation Defense to Dealing with Activists: A First
We have a long history with helping companies solve problems and creating value for shareholders. Rarely do the companies ask for said help. It typically needs to be catalyzed by a displeased shareholder but once companies get to know us they realize we’re on the same side and can be quite helpful. An outside perspective and our network and resources often can cut through the deadlocks within a company to unlock growth and value. This quarter was the first time we have seen a company so uninterested in help from the outside that they decided it was better to fold the tent and wipe out the shareholders completely.
diaDexus was a diagnostic test product company that we have owned a small portfolio position for over a year. They had a modest amount of debt and had been in the midst of launching a new product that had received significant positive coverage in the news to help the early detection of heart disease. Working with another larger long term shareholder, we nominated several directors in order to preserve our rights early this year and met with the management. Our initial meeting was quite positive and we were verbally invited onto the board. And that’s where it started going downhill… The next day rather than a board agreement, we were introduced to their legal process to ‘apply’ to be a director. We played nice and gave references but after getting the run around from their legal team and nom/gov committee we were told our candidates didn’t make the cut. Keep in mind that two of our three candidates could have bought out the entire company with their checking account and we had offered to help refinance the company!
The company went silent for a month, did not announce a date for the impending annual meeting as scheduled the prior year. Then out of nowhere the company announced they were filing for Chapter 7 bankruptcy and liquidating the company and shareholders were wiped out! Never have we seen such anti-social conduct by a board and management teams. Fortunately, it was only about a 1% portfolio position (we recognized the risk and also saw 10X potential so it was sized appropriately). Also, this type of behavior by management and directors is highly predictive of future value destruction and we expect to make short lemonade out of lemons (directors) by keeping up to speed with their future ventures.
Catching the White Whale
Our “white whale” in our portfolio that we have been chasing for 6 years now is SIGA Technologies. We initially purchased a position in early 2010 around $7 per share after it was confirmed they were awarded a large government contract. The company discovered a small molecule cure for smallpox which has great value in the event of an outbreak by bioterrorists. Since 2005, there has been an ongoing lawsuit with a competitor, PharmAthene (PIP) that resembled the dynamic between Facebook and the Winklevoss twins made famous in The Social Network movie. In short, in 2005, SIGA had a drug but needed money, PIP lent some money and they had discussions to merge; SIGA had a breakthrough, got sellers’ remorse and walked, PIP sued. 10 years later… after numerous appeals, the lawsuit was finally completed, new case law was established at the Supreme Court of Delaware. Although there was no binding contract to merge with PIP, SIGA was found to have acted in bad faith and the new case law was that the damages should right the wrong based on the expected value and SIGA owes PIP over $200mm with interest.
We were never positioned to ‘bet’ on the outcome of the unpredictable lawsuit, because both were public companies we were able to hedge that risk by simply owning both companies proportionately over time. After SIGA rose from $7 to $15 shortly after we acquired it in 2010 (we thought it was worth $30/share then, as we still do today). Then things took a turn down in the suit and the painful uncertainty of the ongoing lawsuit depressed the stock to a low of $0.35 at the end of 2015. We were averaging down all the way and managed to lower our cost basis to under $0.75/share! We take investing intestinal fortitude and persistence to a whole new level, playing to our competitive edge. At each step of the way we would double check the facts and the progress: Mr. Market is your opportunity, not your council. Along the way we worked with other investors to make appearances and motions to the court to prevent an unfavorable outcome towards the equity holders which resulted in a number of good governance changes to the restructuring plan following the lawsuit.
As of this writing the stock is now roughly 3 times our cost basis and on its way to recovering. Due to the relatively riskier nature of